Dolby Laboratories (NYSE:DLB)
Q3 2014 Earnings Call
July 24, 2014 5:00 pm ET
Elena Carr -
Lewis Chew - Chief Financial Officer, Principal Accounting Officer and Executive Vice President
Kevin J. Yeaman - Chief Executive Officer, President, Director and Member of Stock Plan Committee
Ladies and gentlemen, please stand by. Welcome to the Dolby Laboratories Conference Call Discussing Fiscal Second -- Third Quarter Results. [Operator Instructions] As a reminder, this call is being recorded. The date is Thursday, July 24, 2014.
I would now like to turn the conference over to Ms. Elena Carr, Director of Corporate Finance and Investor Relations for Dolby Laboratories. Please go ahead, Elena.
Good afternoon. Welcome to Dolby Laboratories Third Quarter 2014 Earnings Conference Call. Joining me today are Kevin Yeaman, Dolby Laboratories' President and CEO; and Lewis Chew, Executive Vice President and Chief Financial Officer.
As a reminder, today's discussion will include forward-looking statements. These statements are subject to risks and uncertainties and may cause actual results to differ materially from the statements made today. As a discussion -- a discussion of some of these risks and uncertainties can be found in the earnings press release that we issued today under the section captioned Risk Factors, as well as in our most recent report on Form 10-Q. Dolby assumes no obligation and does not intend to update any forward-looking statements made during this call as a result of new information or future events.
During today's call, we will discuss GAAP and non-GAAP financial measures. A reconciliation between the 2 is available in our earnings press release and in the Dolby Laboratories Investor Relations data sheet on the Investor Relations section of our website.
As for the content of this call, Lewis will begin with a recap of Dolby's financial results and provide our fiscal 2014 outlook, and Kevin will finish with the discussion of the business.
So with that introduction behind us, I will now turn the call over to Lewis.
Thanks, Elena. Good afternoon, everyone. Let's start by discussing the revenue for the quarter. In Q3, total company revenue was $223.4 million, of which $205.6 million came from licensing and $17.8 million came from products and services.
Our total company revenues were higher than we originally projected, and all of this was driven by licensing, which was $20.9 million higher than last year and down $53 million from Q2, mainly due to seasonality, as well as a $24.7 million back payment that we received in Q2 that did not repeat in Q3.
So let me take you through some details of third quarter licensing revenue by our end markets. Broadcast represented about 43% of total licensing in the third quarter. Revenues in this market were down sequentially by 26%, due to the effect of the $24.7 million item I just mentioned, as well as seasonally lower TV units. Year-over-year, Q3 broadcast licensing grew about 25% due to a combination of higher attach rates in TVs, back payments and higher units in set-top boxes.
PC revenues represented about 19% of total licensing in the third quarter. They were down about 4% sequentially and down about 2% compared to last year's third quarter. Both of these movements are now in the same ballpark as market movement, with some differences mainly due to mix in timing between quarters.
Consumer electronic revenues in Q3 were about 14% of total licensing, which is similar to the 14% they were in Q2 and the 15% in Q3 of last year. They were down about 19% sequentially due to seasonality and up slightly over last year as declines in DVD and Blu-ray were offset by improvements in other areas.
Mobile device revenues were down 20% sequentially and represented about 13% of total licensing in Q3. This was above the original guidance as we saw a little more revenue than expected during the quarter coming in from older Samsung phone models that were available before the Galaxy S5, which is their latest model. Year-over-year, mobile licensing was up about 20%, driven by tablet unit growth and higher mobile phone revenue from a variety of customers.
Revenues in other markets, which primarily includes gaming and automotive, represented approximately 11% of total licensing in the third quarter. Revenues were down about 24% sequentially in Q3, as Q2 had the benefit from higher volume holiday shipments of PS4 and Xbox One gaming consoles.
Year-over-year, other markets was down about 3% due to a onetime license fee for imaging technologies in Q3 of last year that didn't repeat this year. Product and services revenue was $17.8 million in Q3, which was down $2.2 million sequentially from Q2 and down $4.6 million year-over-year, as we continue to work through the maturing phase of the digital equipment cycle that's not fully offset yet by adoption of newer solutions, such as our Dolby Atmos.
On a related topic, we continue to work towards closing the acquisition of Doremi Labs, which we announced a definitive agreement near the end of Q2, and we currently estimate that the deal could close in calendar -- or should close in calendar Q4, perhaps in October. And that's, of course, dependent on regulatory approvals, along with other customary closing conditions.
Let's move on and discuss margins and the rest of the income statement for Q3. Total gross margin in the third quarter was 91.6% on a GAAP basis and 92.6% on a non-GAAP basis. Product gross margin on a GAAP basis was 16.3% in the third quarter compared to 29.3% in Q2 and 6.4% in last year's third quarter. Product gross margin on a non-GAAP basis was 23.4% in the third quarter compared to 35.8% in Q2 and 14.1% in last year's Q3. The decrease from Q2 to Q3 was primarily driven by excess and obsolete inventories.
Operating expenses in the third quarter on a GAAP basis were $153.9 million compared to $156.2 million in the second quarter. On a non-GAAP basis, Q3 operating expenses were $137.4 million, which was essentially the same as the $137 million we had in Q2. Operating income in the third quarter was $50.6 million on a GAAP basis, or 22.6% of revenue, and $69.4 million on a non-GAAP basis, or 31.1% of revenue. The effective tax rate for the quarter was 21.7% on a GAAP basis and 22.1% on a non-GAAP basis.
Net income in the third quarter was $39.8 million on a GAAP basis or 17.8% of revenue and was $54.3 million on a non-GAAP basis or 24.3% of revenue. And diluted earnings per share in Q3 were $0.38 on a GAAP basis compared to $0.73 in Q2 and $0.29 in Q3 of last year. On a non-GAAP basis, Q3 diluted earnings per share were $0.52 compared to $0.88 in Q2 and $0.47 in Q3 of last year.
During the third quarter, we generated $93 million of cash flow from operations, and we also repurchased about $29 million of our common stock during the quarter. And we have about $75 million remaining of stock repurchase authorization.
As of the end of Q3, we had a little over $1 billion in total cash and investments, which includes cash, cash equivalents, as well as both short- and long-term marketable securities.
So looking forward, here is the outlook for Q4 and the full year. In the fourth quarter, we estimate that total revenue will range from $210 million to $220 million. Within that, we anticipate that licensing revenue will range from $190 million to $200 million, and products and services revenue combined would be about $20 million. In our licensing outlook, we anticipate that PC revenues will decrease at a rate similar to the market, which is estimated to be in the down 5% or 6% range for the year. We also are projecting mobile revenues in the fourth quarter to drop from what they were in Q3 and be down around 20% to 25% on a year-over-year basis.
Gross margin in the fourth quarter is estimated to range from 92% to 93% on a GAAP basis and 93% to 94% on a non-GAAP basis. Operating expenses in the fourth quarter are projected to range from $155 million to $158 million on a GAAP basis and from $137 million to $140 million on a non-GAAP basis. Other income in the fourth quarter is expected to be approximately $1 million, and our effective tax rate for the fourth quarter is estimated to range from 25% to 26% on both the GAAP and non-GAAP basis. So based on the combination of the factors I just went over, fourth quarter diluted earnings per share are projected to range from $0.28 to $0.33 on a GAAP basis and from $0.43 to $0.48 on a non-GAAP basis.
Also, using the fourth quarter estimates I just provided, we now estimate that total revenue for the full fiscal year will range from $945 million to $955 million. And within that, we anticipate that licensing will range from $860 million to $870 million, while products and services combined will be about $85 million for the year.
Full year operating expenses are estimated to range from $618 million to $621 million on a GAAP basis and from $542 million to $545 million on a non-GAAP basis. We estimate that full year gross margins on a GAAP basis will range from 91% to 92%, with our non-GAAP gross margins about 1 point higher. Other income is expected to be around $1 million for the year, and the full year effective tax rate is estimated to range from 25% to 26%.
So now I'd like to turn the call over to Kevin Yeaman. Kevin?
Kevin J. Yeaman
Thank you, Lewis, and thanks to everyone for joining us today. We had strong third quarter results, and we continued to have success in developing and maintaining ecosystems around our products and technology, from content creation to distribution and ultimately, to consumer device. Today, I want to update you on our progress and take you through some of our key growth areas.
Let's start with mobile. Revenue was 13% of licensing, which was above the expectation of 10% discussed in the last call. At this time, we do not have an update on Samsung mobile devices. But during the quarter, there were a number of indicators that show that sound and our technology in particular can be a differentiating factor in the mobile ecosystem. As you know from past updates, we have partnered with Amazon to enhance the audio experience in a number of their devices, specifically their full line of Kindle Fire tablets and recently, the Fire TV. During the quarter, Amazon announced the Fire Phone, which will also feature Dolby Audio. Within the Amazon content ecosystem, we are seeing more TV and movie content in Dolby formats and also an increasing number of applications being developed that leverage Dolby technologies to enhance their gameplay and user experience. This demonstrates the value that Dolby can bring to the user experience in broader applications beyond video consumption. One of the most popular Dolby-enhanced applications this quarter was Angry Birds Star Wars II by Rovio. Dolby sound is a differentiating feature across the Amazon platform, and we continue to focus on creating similar value in the other mobile ecosystems.
Now let me move on to broadcast, which, again, showed steady growth this quarter. We have built a strong position in North America and Europe, and continue to focus on extending our technologies into emerging markets, where a large opportunity still exists as the transition to digital broadcast is still at its early stages. We work closely with operators and standards bodies in these regions to adopt our technologies. This strategy is consistent with how we achieved our current success in North America and Europe.
We are seeing more robust content ecosystems developing in China and in India. And as I've highlighted in the past, these are 2 of our largest market opportunities. Currently, about 2/3 of high-definition channels in China are in Dolby. In addition to Hollywood content, we are beginning to see an increase in local content, including documentaries, variety shows, sports and reality TV programs.
Another sign that Dolby is gaining traction in the broadcast content ecosystem is the progress we are making with OEMs. During the quarter, Xiaomi launched its latest TV, which includes the full suite of Dolby technologies. Xiaomi is recognized as one of the most innovative tech companies in China. This win is further evidence of the value Dolby can bring to the TV entertainment experience and that content simply sounds better in Dolby.
In India, we are seeing positive trends. Last quarter, I talked about the inclusion of Dolby in the terrestrial HD set-top box standard. This quarter, 4 cable networks in India adopted Dolby Digital Plus in their HD services, resulting in 9 of the leading cable operators using Dolby Digital Plus. About 2/3 of HD channels are currently in Dolby. During the quarter, Sony Pictures Television began broadcasting in Dolby on 2 of its HD channels in India, and Star TV out of their second sports channel in Dolby.
Beyond China and India, we continue to make progress in other parts of the world. During the quarter, the largest satellite operators in both the Philippines and Vietnam went on in Dolby.
In the Cinema business, our focus continues to be on driving adoption of Dolby Atmos. We have continued to build our momentum with studios, content creators, postproduction facilities and exhibitors. Currently, there are about 640 screens committed to Dolby Atmos, of which over 540 are installed. To date, there are 145 titles released or announced in Dolby Atmos. Of the 15 highest-grossing titles so far in 2014, 12 were in Dolby Atmos, including Transformers: Age of Extinction and X-Men: Days of Future Past.
It's also worth mentioning that we are having great success in the fast-growing China market. As of this quarter, there are about 110 Dolby Atmos screens installed in China. Additionally, during the quarter, Farewell My Concubine had its international premiere at the Dolby Theatre in Hollywood, and this marks the first foreign film premiere in Dolby Atmos at the Dolby Theatre.
Now I'd like to move on to discussing our progress in bringing new solutions to market. We're seeing good early adoption and ongoing deployment of Dolby Voice. During the quarter, there were over 50 organizations in active trials of BT MeetMe with Dolby Voice, and currently 16 customers are in contract for the service. The adoption is driven by the value the service brings to audio conferencing. BT MeetMe with Dolby Voice gives attendees the sound and feel of in-person meetings through outstanding fidelity and suppression of background noises. The service not only provides a superior experience, it can also reduce conferencing costs for enterprises.
Last quarter, I highlighted 2 new elements that will further enhance the Dolby Voice experience: the Dolby Voice Conference Phone and the Dolby Voice mobile application. As a result, Dolby Voice will be available anywhere with desktop, mobile and conference phone access options. We expect the conference phone to be available for purchase later this year, and the mobile application is currently available.
Turning to Dolby Vision. We expect to see televisions with Dolby Vision shipping by the end of the year. We are seeing great support from the content community, and we continue to focus on building out the ecosystem for this end-to-end solution. Dolby Vision offers more realistic distinctions in color and brighter highlights while also delivering improved shadow details. It focuses on the quality of the image each pixel represents and is not dependent on the number of pixels.
In summary, we had a strong quarter. We have increased our revenue outlook for the year again, and we're delivering overall top line growth. As I went over with you on today's call, we are focused on gaining traction in all of the ecosystems in which we provide solutions. We have seen good signs of progress across the board and remain confident that our core markets, along with our new offerings, will further drive long-term growth.
And with that, I'll turn it over to Q&A.
[Operator Instructions] And we will take our first question from Mark Gilbert [ph] with Voya.
I'm just looking at the cash balance and the free cash flow that you are generating with a relatively good stability quarter-over-quarter. And it looks like even with the acquisition from Doremi and even with the $29 million in repurchases, you're generating cash a lot faster than you're returning it back to shareholders. Do you have any intent or are you looking at considering any other options of cash return? Because the company is starting to look a little bit over-capitalized.
Mark, this is Lewis Chew. Would it shock you if I said that that's the first time I ever heard that question?
Yes, it would.
Yes. No, I'm just kidding. Yes, this is one of the things that the management team pays attention to and has done a lot about. As you mentioned, we have an upcoming acquisition. We've announced that the acquisition is expected to be in the $100 million range, so I wouldn't call that a small sum of money. But yes, I think if I look back over a longer period than just -- and by the way, this quarter, we did buy back stock. But over a longer period of time, let's say, over the last 3 years, we've generated, during that time window, just over $1 billion in cash from operations and we've actually returned about $950 million in cash back to shareholders over that period of time. So I think that alone suggests that we did -- do not ignore that topic. I think there's always a day -- a debate about what is the right level of cash, and all I can say is we continue to pay attention to that and find ways to return cash to shareholders.
Kevin J. Yeaman
All right. Well, I want to thank everyone for joining us today. Again, we're pleased that we had a strong quarter, continued to make some really good progress on our new initiatives, like Dolby Vision and Dolby Voice. And it gives us confidence that we're on track to generate long-term growth. And so thank you for joining and look forward to speaking with you soon.
And ladies and gentlemen, that does conclude today's conference. We do thank you for your participation. You may now disconnect. Have a great rest of your day.
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